IS RISK SYSTEMATICALLY REDUCED BY SELECTING SHORT DURATION BONDS? PART 2

Our last article gave a positive answer to the initial question. We are going to see now that the answer can be quite different because of the Credit risk (risk linked to the bond issuer).  

Repayment schedule pressure

For an issuer, a short bond is synonymous with a forthcoming repayment to be made. It is a constraint on its liquidity, which must be sufficient on the scheduled date to honor the debt.

In general, an issuer very rarely redeems its debt with its own cash, but rather seeks fresh refinancing on the bond market, meaning that it borrows the required amount several months before maturity, again for a long duration. Liquidity is usually used for paying dividends to shareholders and/or making minor acquisitions and investments without having to justify them either to the banks or to the markets. The presence of liquidity is also a means for an issuer to limit its leverage (since with respect to the notion of debt, gross debt minus available cash is what is considered).

However, there are cases where an issuer can have great difficulty in raising fresh cash on the bond market: issuer’s bad image on the market (in the case of scandals), unfavorable market context (too high a level of volatility), financial profile that has become too fragile (severely downgraded rating) or the cost is deemed too high by the issuer. And banks do not necessarily lend easily in these circumstances.

Maximum risk for an investor when the liquidity situation has deteriorated

The issuer can find itself in a situation of default on its bond if ever the following points, specific to its liquidity situation, are borne out:

• Little available cash.

• Few cash flows generated by the issuer’s business (or even presence of negative free cash flows).

• Credit lines confirmed with banks already fully used.

• Impossibility to obtain further credit lines from banks (because of breach of covenants, for example).

• No rapid asset disposals possible (non-core activities) to free up cash.

• Dividend payment already suspended.

• Difficulty in making a capital increase, finding a partner to enter the capital or carrying out an IPO.

In this case, despite holding a short maturity bond, the risk of loss becomes maximal for an investor because the issuer cannot even make repayments on time with its own cash.

A recent concrete example: Abengoa

The Spanish industrial group Abengoa (28,700 employees) has been the subject of numerous articles in the financial press for several months. This heavily indebted issuer is in a very complicated financial situation that could result in a default. The repayment schedule of its debt is now under strong pressure: one of its bonds matures on 31 March 2016. Abengoa will then have to repay 500M euros plus the interest of 42.5M euros. But the market no longer wants to lend to this issuer as it considers the risk of default to be very probable.

Abengoa’s liquidity situation does not enable it to repay this debt with its own cash either: the company does not even have any available liquidities for paying December’s salaries. The banks that usually deal with Abengoa have finally agreed for an emergency loan only for this purpose. Other avenues are being explored to free up liquidity before March (asset disposals, bank support or capital increase) but they all seem relatively complicated to put in place. That is also why the yield on Abengoa’s 2016 bond is much higher than that on its longer-dated bonds and its price has fallen from 100% to 15% in 4 months!

Therefore, we can encounter cases of bond issuers very close to a default situation whose short-term bonds are as risky as their longer bonds because the available cash no longer exists for paying the forthcoming liabilities.